Scott Burns: Retiree should look at ETFs as Roth IRA substitute

April 21, 2013Updated: April 21, 2013 10:34pm

Q:﻿﻿﻿ Last night I came to the realization that I'm not allowed to contribute to my Roth IRA if I have no earned income, which I don't. All I have is my teacher retirement income. Bummer. This is a kink in my plan. I wanted to put away about $5,000 a year in the Roth IRA and let it grow tax-free. Where should I put my money to make the most of it? What are my options? Cut expenses? Tax-exempt fund? Annuity? Get a job? I really don't want to work, or cut expenses (I've done that). My tax rate is around 15 percent.

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A: The tax efficiency of the broad exchange-traded index funds (ETFs) that invest in equities is quite powerful, particularly since dividend yields are so low. This is also a place where the tax accounting for regular investments comes in handy.

If you were to invest in a tax-deferred annuity, the return on your investment would be the first dollars to come out, so every dime of withdrawal is immediately taxable. Investing in a taxable stock, on the other hand, allows you to realize only the proportion of appreciation that you experienced on your actual shares sold. So if you make a $10,000 investment and it doubles in 10 years, you can sell half of it and recoup $10,000. Your taxable gain on that $10,000 sold, however, will be only $5,000.

Q: My husband's job was eliminated last April. He has a 401(k) worth around $200,000. We know we need to reinvest it somewhere, but have no idea what to do with it. He is 60 and I am 56. Neither of us plans to retire in the near future. Should we roll it over into an IRA? Or divide it up between various other investments?

We've gone to a broker, and the information he gave us makes us feel that most of our income generated from the investment would be spent on fees. We aren't very savvy when it comes to investing and feel a little lost. What do you suggest?

P.E., Austin

A: The best course of action would be to do an IRA rollover from the 401(k) account to a new account at a place such as Schwab. It has quite a few offices, so someone can walk you through the process in person if need be. To keep expenses low, you can invest the proceeds very simply in a variation of one of my Couch Potato portfolios.

You could, for instance, keep it really simple and divide your investments equally between Schwab U.S. Broad Market ETF (ticker: SCHB), which has an expense ratio of 0.04 percent, and Schwab U.S. TIPS ETF (ticker: SCHP), which has an expense ratio of 0.07 percent. At an average cost of 0.055 percent, your investment expenses would be nominal. You can learn more about these ETFs at schwabetfs.com/overview.asp.

Investment advisers tend to pooh-pooh client concerns about the costs of investing, acting as though high expenses were the only way to achieve superior performance. Unfortunately, the reality is that expenses have a big impact on performance, and what seems like a minor cost, say 1 to 1.5 percent, will work to reduce both your income and your long-term performance.

Let me give you an example: At the end of 2012, the Morningstar Principia database showed that the average net expense ratio for all “moderate allocation” funds (think balanced funds) was 1.33 percent. This is quite a bit more than the 0.055 percent expense for investing in low-cost, no-commission ETFs. But over the last three years, a fund at the 25th percentile (meaning that it has done better than 75 percent of its competition) provided an annualized return of 8.69 percent, while a fund at the 50th percentile provided a return of 7.67 percent. In other words, a cost difference of “only” 1.02 percent took performance down a full 25 percentile, from superior to median.

Doing the same measurement over the last 10 years shows that a fund in the 25th percentile provided a return of 7.19 percent, while a fund in the 50th percentile returned only 6.40 percent, a difference of 0.79 percent. While these spreads change from month to month (and asset class to asset class), the reality is that the cost of investing has a major impact on the return you receive.

Questions about personal finance and investments may be sent by email to scott@scottburns.com. Please visit www.assetbuilder.com to comment on any of his articles, to find referenced Web links or to discuss personal finance topics on his forums. Questions of general interest will be answered in future columns and on the website.